Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Don't Invest in the Most Valuable Business

Why it fails to invest at the point of maximum optimism.

In an earlier article, I discussed the characteristics that one notices among the investing greats. Aside from having a good search strategy and the ability to assess the values of the business, all great investors have always had the courage to make significant investments in a business during maximum points of pessimism.

Warren Buffett did just that with American Express (NYSE:AXP) in the '60s, Washington Post (NYSE:WPO) in the '70s, and GEICO in the '80s. Mohnish Pabrai did it recently with big investments in Pinnacle Airlines (NASDAQ:PNCL) and Harvest Natural Resources (NYSE:HNR). Years before that, in 1939 after World War II broke out, Sir John Templeton, considered one of the greatest stock pickers of the 20th century, borrowed money and bought 100 shares in each of 104 companies selling at $1 or less.

If such investing luminaries exhibit similar traits in their investing activities, it pays to go deeper into their approach. The opposite approach would be to invest in a business at the maximum point of optimism. It would make sense that the most highly valued business in the world would fit that description.

According to Forbes and Value Line, below are the most valuable Fortune 500 companies from 1987 to 2002. (Figures in billions.)

Year

Company

Market Cap

Revenue

Net Income

1987

IBM

$89

$51

$4.8

1988

IBM

$68

$59

$5.8

1989

IBM

$70

$63

$5.2

1990

IBM

$61

$69

$6.0

1991

IBM

$75

$65

$2.1

1992

Exxon

$69

$103

$4.8

1993

Exxon

$78

$100

$5.3

1994

GE

$90

$60

$5.9

1995

GE

$92

$70

$6.6

1996

GE

$126

$79

$7.3

1997

GE

$170

$91

$8.2

1998

GE

$260

$100

$10.7

1999

Microsoft

$419

$20

$7.6

2000

Microsoft

$492

$23

$9.4

2001

GE

$407

$126

$14.1

2002

GE

$401

$131

$16.6

Pabrai examined this list and determined that if you had started with $10,000 invested in the most valuable businesses in 1987, when Fortune released its list, and every subsequent year reinvested the funds in what was at the time the most valuable business, in 2002 you'd have an annualized gain of 3.3%. During the same period, the S&P delivered about a 10% annualized return.

You can clearly see from the results that the maximum pessimism approach would yield a far more superior result. As the saying goes, what has risen shall fall, and what has fallen shall soon rise again. Surely not every stock that deteriorates will again rise -- it's up to you to provide the thorough analysis and determine whether or not a superior investment opportunity exists.

An intelligent investment approach demands that you remember Buffett's two rules of investing:

Rule 1: Never lose money.

Rule 2: Never forget Rule 1.

Generally, investing in a business during the rosiest of times usually means you're paying a high premium for a cheery consensus. It also means you're investing without any meaningful margin of safety. During bull markets, this approach will surely be confused with an intelligent approach as a rising tide will lift all boats. Then again, if all we had were bull markets, a "value investing" approach would not be needed since all the attributes of investing -- exercising due diligence, investing with a margin of safety, looking for companies with excellent economics and honest and able management -- are for the purpose of weathering the bear market storms and emerging with your capital intact.

As Sir John Templeton brilliantly remarked, "The four most dangerous words in investing are 'This time it's different.'"

Fool contributor Sham Gad runs the Gad Partners Fund, a value-oriented, Buffett-modeled investment partnership. He has no positions in the companies mentioned. Microsoft is an Inside Value recommendation. The Fool has a disclosure policy.